House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

General outline and financial impact

Removal of the taxing point on conversion or exchange of certain traditional securities

This bill proposes to remove the taxing point at conversion or exchange of certain financial instruments. The proposed amendments:

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will remove the taxing point when traditional securities issued after the date of effect convert or exchange into ordinary shares;

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will insert a new Subdivision (Subdivision 130-E) into the CGT provisions that will ensure that the amount of gain or loss recognised for income tax purposes is correctly calculated, by modifying the cost base and reduced cost base of shares acquired on the exchange of an exchangeable interest; and

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will amend the cost base and reduced cost base CGT provisions relating to the conversion of convertible interests and the exercising of rights, to ensure that the amount of gain or loss recognised for income tax purposes is correctly calculated.

Date of effect: After 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002 for the proposed amendments to remove the taxing point on conversion or exchange of certain traditional securities. The consequential changes in relation to the conversion of convertible interests and the exercise of rights will apply from 1 July 2001.

Proposal announced: The removal of the taxing point on conversion or exchange was announced in Minister for Revenue and Assistant Treasurer's Press Release No. C57/02 of 14 May 2002.

Financial impact: This measure will have no impact on the revenue over the forward estimate period. As the measure will apply to issues of traditional securities that are convertible interests or exchangeable interests issued after the date of effect there is unlikely to be any impact on the revenue until 2006-2007 because conversion or exchange is unlikely to occur before then. Whether the measure will have a positive or negative impact on the revenue after that will depend on the extent of gains and losses made on conversion or exchange.

Compliance cost impact: The measure will have a minor compliance impact on the issuers of traditional securities that are subject to the measure. However, the measure will reduce the compliance costs of investors in these traditional securities.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure will impact on companies, which are the predominant issuers of traditional securities that are convertible interests or exchangeable interests that will or may convert or exchange into ordinary shares. The measure will also impact on superannuation funds, large/medium business, small business, and individuals to the extent that they invest in these traditional securities.

Main points:

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This measure will prevent potential cash flow difficulties arising where the holder of traditional securities that convert or exchange into ordinary shares does not have the cash from the conversion or exchange to pay the tax on conversion or exchange gains. This is designed to remove an impediment to the issue of such instruments.

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The affected issuers of these traditional securities will be potentially any company but mainly small and medium sized companies, new ventures and expanding companies that have a sophisticated understanding of the tax law and have ready access to high level tax advice so that they will quickly and easily understand the changes to the law.

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Affected issuers will need to inform holders if the tax treatment of their securities changes. However, it is not expected that this will often occur, because this measure does not affect traditional securities issued before its date of effect.

Foreign currency gains and losses

This bill also outlines the proposal to address a number of uncertainties and anomalies relating to the tax treatment of foreign currency. The proposed amendments:

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introduce a general translation rule into the income tax law that converts foreign currency denominated amounts into A$ so that Australian income tax liability is calculated by reference to a common unit of account. This general rule covers payments, receipts, rights and obligations denominated or expressed in a foreign currency;

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introduce 'functional currency' rules, under which the net income or loss of an entity (or specified part of an entity) that functions predominantly in a particular foreign currency can under certain circumstances be determined in that currency, with the net amount being converted into A$;

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introduce a core realisation principle into the income tax law which, together with the translation rule, ensures that foreign currency gains and losses are brought to account when realised, regardless of whether there is an actual conversion of foreign currency amounts into A$. This reform addresses a number of uncertainties and anomalies under the current law's treatment of foreign currency gains and losses;

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ensure that foreign currency gains and losses have a revenue character, subject to limited exceptions. This is done by including foreign currency gains in assessable income, and treating foreign currency losses as allowable deductions, when they are realised;

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implement exceptions to the timing and characterisation aspects of the realisation approach where the foreign currency gain or loss is closely linked to a capital asset. Broadly, and subject to a once-off election available for a limited time:

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any foreign currency gain or loss on a transaction to acquire a depreciating or capital asset is included in the cost of the asset if the gain or loss arises before the asset is recognised for tax purposes, or as long as the payment is to occur not more than 12 months after the time the asset is acquired; and

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any foreign currency gain or loss on a transaction to dispose of a depreciating or capital asset will be incorporated into the disposal proceeds of the asset to the extent that the gain or loss arises before the time that the asset is disposed of for tax purposes. Any foreign currency gain or loss on a transaction to dispose of a capital asset arising after the time of disposal will be treated as a capital gain or loss if the payment is to be made not more than 12 months after the disposal of the asset;

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provide optional roll-over relief for foreign currency gains and losses to an issuer under certain finance facility agreements; and

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provide optional treatment to assist taxpayers in reducing compliance costs associated with foreign currency denominated bank accounts. In addition to the normal treatment which is available under the proposals (FIFO), 2 additional options for accounting for certain foreign currency denominated bank accounts are:

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the limited balance or de minimis account exemption. This allows foreign currency gains and losses on low balance transaction accounts to be disregarded; and

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the retranslation option. This allows gains and losses to be brought to account by annually restating the balance of the account by reference to the exchange rate prevailing at the beginning and the end of each year and taking into account withdrawals and deposits at the exchange rates prevailing at the time of the respective withdrawals and deposits. It removes the requirement to calculate a foreign currency gain or loss on each withdrawal from the account.

Date of effect: It is proposed that the legislative amendments apply to:

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all foreign currency gains and losses on transactions entered into in or after the first income year commencing on or after 1 July 2003; and

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at the option of the taxpayer, foreign currency gains and losses on transactions entered into prior to the first income year commencing after 1 July 2003 but realised after that time.

This prospective application means that the amendments will not disturb prior year assessments, nor bring to account for taxation purposes, other than at the option of the taxpayer, foreign currency gains and losses on transactions entered into prior to the date of effect.

Proposal announced: This proposal was announced in Minister for Revenue and Assistant Treasurer's Press Release No. C57/02 of 14 May 2002. An exposure draft of these measures was released for public comment (Minister for Revenue and Assistant Treasurer's Press Release No C132/02 of 17 December 2002).

Financial impact: The impact on the revenue is unquantifiable. However, the proposed reforms to the taxation of foreign currency gains and losses is expected to protect the revenue base which is potentially at risk of being eroded due to the uncertainties with the current tax law.

Compliance cost impact: The proposed roll-over relief for securities issued under a facility agreement, the functional currency provisions and the options available for foreign currency denominated bank accounts are expected to lower compliance costs relative to the current law. There may be some small compliance costs for taxpayers in the short term as they familiarise themselves with the new law.

Summary of regulation impact statement

Regulation impact on business

Impact: These measures will affect all taxable entities, other than ADIs and non-ADI financial institutions, with transactions denominated in a foreign currency.

Main points:

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The reforms address a number of uncertainties and anomalies under the current law's treatment of foreign currency gains and losses.

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The reforms will improve neutrality, clarity and certainty in relation to the taxation of foreign currency gains and losses.

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The proposed roll-over relief for securities issued under certain facility agreements, the functional currency provisions and the options available for foreign currency denominated bank accounts, are expected to lower compliance costs relative to the current law. There may be some small compliance costs for taxpayers in the short term as they familiarise themselves with the new law.